In the financial markets, there are various types of credit derivative financial instruments. A credit default swap (CDS) is one type of credit derivative. A CDS allows credit risks to be traded and managed in a manner similar to that of market risks. A CDS is a contract that provides insurance against default by a particular company. With a CDS, a seller receives a fee in exchange for making a contingent payment if there is a Credit Event (default) of the Reference Entity (the company). The Credit Event may be a bankruptcy, an insolvency, a receivership, a material adverse restructuring of debt, or a failure to meet payment obligations when due. The CDS buyer has the right to sell the Reference Obligation, at the Reference Obligation's par value, when the Credit Event occurs. The total par value of the Reference Obligation (bond) that may be sold is the notional principal of the CDS. The contingent payment may be in cash or may involve the physical delivery of the Reference Obligation. The “spread” of the CDS is the total of the payments per year, as a percent of the notional principal. The spread may be indicated in basis points, where 100 basis points correspond to one percent.
In particular, the buyer of the CDS makes periodic payments to the seller until the end of the life of the CDS or until a Credit Event occurs. A Credit Event usually requires a final accrual payment by the buyer. The credit default swap is then settled by providing physical delivery or cash. If the credit default swap terms require physical delivery, the swap buyer delivers the bonds to the seller in exchange for their par value. If there is a cash settlement, the “calculation agent” polls dealers to determine the mid-market price (Q) of the reference obligation a specified number of days after the Credit Event. The cash settlement is then (100−Q) percent of the notional principal.
Thus, with a CDS, a buyer gains credit protection on the Reference Entity and a seller assumes the default risk of the Reference Entity.
On any given trading day, there may or may not be an actual value quoted for the spread of a CDS having a particular term and/or for a particular company. If there is no quote for such a CDS spread, then the CDS spread (for a particular company and/or having a particular term) must be estimated.
The CDS spread (for a particular company and/or having a particular term) may be part of a rating category associated with a particular credit rating or a particular industry sector, such as, for example, aerospace, automotive, steel, etc. Spreads for companies in a particular rating category are not the same, but have a tendency to move together. The companies in a particular rating category change through time. Based on trading information, the CDS spreads have been commonly quoted for instruments that have maturities of approximately five years.